Experts are saying that 2014 will be a year of continued growth for the housing market, with fewer foreclosures and more activity among underwater homeowners.

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After years of struggles, the housing market roared back to life in 2013. The rebound will continue in 2014, but the pace will slow.
Experts say 2014 will be a year of continued growth and stabilization in the housing market with rising home prices, fewer foreclosures, and greater activity among underwater homeowners. But this year's market faces strong headwinds, as inventory remains tight and both homebuyers and builders face tough lending standards.

To buy a home in today's market, you either need impeccable credit or the ability to make an all-cash purchase. The average FICO credit score on conventional loans used to purchase homes in November 2013 was 756, according to the most recent data from Ellie Mae, a company that produces mortgage underwriting software. The average score for denied applications was 729.

"To put that in perspective, the normal average acceptance score historically is around 720," says Walter Molony, a spokesman for the National Association of Realtors (NAR). "Right now, the average rejection score is now what the acceptance score was historically."

Don't expect credit standards to ease up any time soon. This month, new Dodd-Frank regulations aimed at preventing risky borrowers and equally risky mortgage products from entering the market take effect. The new changes require lenders to closely evaluate such factors as a borrower's debt-to-income ratio, employment status, income, assets, and credit history before underwriting a loan.

Home Prices Continue to Climb

In addition to tight credit, rising interest rates and home prices may discourage buyers from purchasing in 2014, says Jed Kolko, chief economist for Trulia.com (NYSE:TRLA), the real estate site. Average 30-year mortgage rates bounced from 3.34% last January to their current 4.48% rate, with many expecting further increases of up to a full percentage point in the New Year. Home prices nationwide have risen 11.2% on average over the past year, according to the S&P/Case-Shiller home price index. Sunbelt cities in places like California and Arizona have seen home values surge in excess of 20%.

While it remains a sellers' market, price gains aren't all bad news for buyers. First-timers may be discouraged, but increasing prices are music to the ears of current owners, many of whom are watching their formerly underwater homes gain value. More than 85% of homeowners with a mortgage in the second quarter have some equity in their home, up from less than 75% in the fourth quarter of 2011, according to CoreLogic.

"We saw a period where the first-time buyer was sort of a driving force," says Robert Denk, senior economist for the National Association of Home Builders. "We expect that to reverse.... As house prices rise, as fewer mortgages are underwater, that should bring the more established [buyers], the trade-up market, back to some degree."

How much the housing market bounces back in 2014 also depends on construction activity. With builders still fiscally cautious and facing the same tight lending environment as buyers, expect a small increase in the number of new homes on the market. As buyer demand picks up, the pace of new home construction should follow.

"The [housing] bust was basically a five-year period where we produced and sold a fraction of the homes we would see in that normal market," Denk says. "We're going to see a lot of that pent-up demand turn into realized demand. That will be an important driving force in 2014 and 2015."

Inventory Remains Tight

Still, the gains in demand (and the inventory that follows) will be slow. While total housing inventory declined in both October and November of 2013, unsold inventory is currently 5% higher than it was a year ago, according to NAR. The association predicts inventory won't radically accelerate until 2015.

"I think 2014 will be the year when we see that home price appreciation pulls back to more normal, sustainable levels," says Daren Blomquist, vice-president of RealtyTrac.com, a site that aggregates real estate data. Markets that boomed in 2013 will likely scale back to more modest growth in the low double-digits, while nationwide growth should average about 4.5%, according to Blomquist.

Even with recent gains factored in, most markets are not at risk right now for another housing bubble. Nationally, home prices remained 4% undervalued in the third quarter, according to Trulia's Bubble Watch. Only Orange County, California, and Los Angeles are more than 10% overvalued, the report finds.

The hottest markets for 2014 won't be in the big cities. A joint study of more than 1,000 real estate industry experts done by PwC and the Urban Land Institute ranks real estate prospects in smaller secondary markets including Houston, San Jose, Dallas/Fort Worth, and Austin above those in larger cities like Chicago, Atlanta, and Washington, D.C., where "there's a lot of money chasing a few assets," says R. Byron Carlock, Jr., PwC national real estate practice leader.